This briefing sets out a comprehensive summary of the BCBS-IOSCO margining framework, meant to set to the industry standard worldwide, to be followed by the European Union, the US and most jurisdictions, and whose compliance is set to start on 1 September 2016.

Timeline

In 2011, the G20 agreed to add to their wide-ranging financial reform programme margining requirements for derivatives not subject to central clearing and tasked the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) with the development of global standards.

The BCBS and IOSCO released for consultation an initial proposal in July 2012 and a subsequent, near-final document in September 2013, seeking comments on a reduced number of matters in the near-final margining framework.

As a result of the market responses to the September 2013 document, the BCBS and IOSCO issued their final margining framework on 18 March 2015, including a nine-month delay for implementation compared to the 2013 framework.

Aim.

For the BCBS and IOSCO, the aim of the margining requirements for non-cleared derivatives is mainly to reduce systemic risk and promote central clearing, whilst keeping an eye on liquidity drain.

Initial margin.

Initial margin is security posted or collected at the transaction’s inception, calculated as an estimate of future exposure. If there is a netting set of transactions, initial margin will be calculated taking into account all such transactions.

Initial margin is posted on a gross basis (i.e., it cannot be netted), must be segregated with an independent third party custodian and cannot be re-hypothecated, re-pledged or re-used, save for very limited circumstances.

This has two immediately apparent implications. Firstly, it has a measurable impact on liquidity, as it requires both parties to transfer to the other assets that will stay frozen with a custodian instead of put to any productive use. Secondly, segregation with an independent, third party custodian eliminates the counterparty’s credit risk but introduces the custodian’s own.

Because of the latter consideration, The BCBS and IOSCO encourage jurisdictions to review their local laws to ensure that initial margin is to be sufficiently protected in case of insolvency of the collateral custodian.

Covered entities.

All non-centrally cleared derivatives to which a systemically important financial institution is a party[1] are subject to the margining requirements. In other words: systemically important financial institutions shall be required to post and collect initial and variation margin on all non-centrally cleared derivatives.

Sovereigns, central banks, multilateral development banks and the Bank for International Settlements are exempted from the margining requirements.

Phase-in period and threshold.

The initial margin requirements are subject to a phase-in period, set out under the heading “Implementation” below.

By the end of the phase-in period (i.e., from September 2020 onwards), any covered entity belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April, and May of the year is greater than €8 billion shall be subject to the initial margin requirements.

The requirements to exchange two-way initial margin is subject to a threshold of € 50 million[2] in aggregate outstanding gross notional amount, which shall be calculated by taking into account the aggregate exposure of all non-cleared swaps between a covered entity’s consolidated group and its counterparty’s consolidated group.

The initial margin baseline is to be calculated as an extreme but plausible estimate of an increase in the value of the non-cleared derivative that is consistent with a one-tailed 99% confidence interval over a 10-day horizon,[4] based on historical data that incorporates a period of significant financial stress.

Initial margin may be calculated based on:

a quantitative portfolio margin model; or

a standardised initial margin schedule.

If a quantitative portfolio margin model is to be used, it must be previously approved by the relevant national regulator and subject to adequate monitoring and periodic re-calibration, among other requirements. Otherwise, the BCBS-IOSCO standardised initial margin schedule may be used.

Once a calculation method is chosen for any given asset class, a covered entity’s calculation method must remain consistent over time, meaning that the covered entity may not switch between quantitative portfolio and standardised schedule calculation methods depending on which one provides the most favourable initial margin terms.

Note, however, that a covered entity may apply different calculation methods to different asset classes.

BCBS-IOSCO standardised initial margin schedule:

Asset class

Initial margin requirement (% of notional exposure)

Credit: 0–2 year duration

2

Credit: 2–5 year duration

5

Credit: 5+ year duration

10

Commodity

15

Equity

15

FX

6

Interest rate: 0-2 year duration

1

Interest rate: 2-5 year duration

2

Interest rate: 5+ year duration

4

Other

15

Variation margin.

Variation margin is security posted or collected during the course of a transaction or a netting set of transactions, as the result of fluctuations in actual exposure.

Variation margin does not need to be segregated with an independent custodian and may be re-hypothecated, re-pledged or re-used.

Covered entities.

All financial firms as well as systemically important non-financial firms are covered entities required to post and collect variation margin.[5]

Central banks, sovereigns, multilateral development banks, the Bank for International Settlements, and non-systemic, non-financial firms are exempt.

Phase-in period and threshold.

There will be no phase-in period for variation margin requirements, and the threshold is zero. In other words, subject to a minimum transfer amount of € 500,000,[6] variation margin must be exchanged, probably on a daily basis.

Eligible collateral.

The list of eligible collateral is to be developed by each national regulator.

Under BCBS-IOSCO’s framework, eligible collateral:

should be reasonably diversified;

should include assets that are normally liquid, including equity and debt securities with a suitable haircut; and

should not be exposed to excessive credit, market or FX risk.

In addition, the “wrong way risk” is to be avoided by ensuring that the value of the collateral is not significantly correlated with the creditworthiness of the covered entity’s counterparty, or with the value of the non-cleared derivatives portfolio with such counterparty in such a way that would undermine the mitigation otherwise afforded by the margin collected.

Securities issued by the counterparty or its related entities constitute an example of collateral assets that pose wrong way risk.

Below is a list of assets that would meet the eligible collateral criteria:

Cash;

High-quality government and central bank securities;

High-quality corporate bonds;

High-quality covered bonds;

Equities included in major stock indices; and

Standardised haircut schedule.

Asset class

Haircut (% of market value)

Cash in same currency

0

High-quality government and central bank securities: residual maturity less than one year

0.5

High-quality government and central bank securities: residual maturity between one and five years

2

High-quality government and central bank securities: residual maturity greater than five years

4

High-quality corporate and covered bonds: residual maturity less than one year

1

High-quality corporate and covered bonds: residual maturity greater than one year and less than five years

4

High-quality corporate and covered bonds: residual maturity greater than five years

8

Equities included in major stock indices

15

Gold

15

Additional (additive) haircut on asset in which the currency of the derivatives obligation differs from that of the collateral asset

8

Inter-affiliate trades.

The BCBS-IOSCO framework leave it to each national regulator to decide whether margining should apply to non-cleared inter-affiliate derivatives, and the applicable conditions in each case.[7]

Cross-border considerations.

The BCBS and IOSCO recommend close cooperation between international regulators to identify inconsistencies and conflicts across different jurisdictions in order to minimise the scope for regulatory arbitrage.

Also, as per the final BCBS-IOSCO framework, “(t)he applicable netting agreements used by market participants will need to be effective under the laws of the relevant jurisdictions and supported by periodically updated legal opinions. Supervisory authorities and relevant market participants should consider how those requirements could best be complied with in practice.”

This is an extremely important point often overlooked by regulators, which has implications for both parties.

If the covered entity’s counterparty is a financial firm from a country where the close-out netting or the validity of collateral agreements are not recognised or present serious doubt, the covered entity should not be required to apply the margining requirements, as that would likely increase risk, rather than mitigate it.

Implementation.

The table below shows the implementation schedule for initial and variation margin as per the final framework. Note that these implementation dates reflect a nine-month extension in respect of the BCBS-IOSCO framework proposed in September 2013.

[1] The BCBS-IOSCO approach, which is to be adopted pretty much “as is” in the European Union, has a more restrictive scope than that proposed by the US prudential regulators and the CFTC.

All swap dealers, major swap participants, security-based swap dealers and security-based major swap participants (collectively called “swap entities”) are covered entities for margining purposes in the US proposed rules in respect of all non-cleared swaps with all parties other than non-financial end users, irrespective of whether the covered entities are systemically important or not.